CHAPTER ONE

INTRODUCTION

1.1       BACKGROUND TO THE STUDY

Auditing standards permit external auditors to rely on the work of internal auditors in performing a financial statement audit (AICPA 1997; PCADB 2004; PCAOB 2007). It stands to reason that cost savings can be realized when external auditors are able to rely on a client’s internal audit function (IAF), and in a competitive audit market a large portion of these cost savings are likely to pass to the client in the form of lower external audit fees. This study investigates the relation between the contribution that internal audit makes to the financial statement audit to the external audit fees. Using a unique and previously unavailable old internal audit data, we improve on the work by creating or introducing quality-related internal audit measures and thereby attempt to better specify the relation between internal auditing and external audit fees. The internal control system of an organization to a large extent determines the audit fees of an external auditor. If the internal control system of an organization is strong the external auditors will have a shorter duration to work and low fees as well will be paid to the external auditors but if the internal control system of an organization or a firm is weak then the external auditor will have much work to do, for a longer duration and a higher audit fees will be paid to the external auditor. Also, the higher the turnover of a company the higher the professional fees charged by the external auditors.

Range of terms was employed to describe this research, they include “internal audit” “external auditing” “internal control system”. Internal audit is an independent appraisal function within an organization for the review of systems of control and the quality of performance, as a service to the organization. It objectively examines, evaluates and reports on the adequacy of internal control as a contribution to the proper, economic, efficient and effective use of resources. (Millichamp, 1993), also internal control system is the whole system of controls, financial or otherwise established by management in order to carry on the business of the enterprise in an orderly manner, safeguard its assets and to secure as far as possible the accuracy and reliability of its records (Oladipupo, 2005).

According to William Thomas, Emerson .O. Henke, 1983, Internal control system is the record and summary of accounting data in an organization. The professional role of the independent external auditor is to express an opinion in the true and fair view of the financial statement audited. In other words, he is there to protect the interest of shareholders and other parties that make use of the financial statement in decision-making. The auditor provides other services apart from auditing the firm which include accountancy taxation, liquidation and receivership, investigation management advisory services, the auditor usually prepares a separate letter of engagement and separate fees should be charged. The fees charged for these services is normally not part of the audit fees charged. Audit fee relates to audit exercises but when an auditor writes the books, prepares bank reconciliation statements or the final accounts (which are frequently done in practice in the audits of many private limited liability companies in Nigeria and other developing country) a separate fee called accountancy will be charged. This is so because such functions are not normally part of the audit functions but rather are accounting functions (Izedonmi, 2000). The time spent in performing financial audit tasks, and time spent providing assistance to the external auditor (work performed) relates with the expectations, which more competent internal audit function associates with lower unexpected audit fees. Companies that have internal auditors have a lower unexpected external audit fee. (Wood D.A., 2007).

1.2       STATEMENT OF THE PROBLEM

In outlining various approaches to internal auditing and external audit fees a number of problems will be discussed. The trouble but largely inconclusive findings have resulted in several calls for additional research to better understand the relation between internal auditing and external audit fee (Felix, Gramling, and Malleta, 1998; Hay, 2006). Further analysis suggests that clients can affect the extent of internal auditing by investing in internal audit quality and depending on the level of inherent risk, by either managing internal audit availability or facilitating greater coordination between internal and external auditors. The problem stated above does not imply damaging situation has developed, it is as a result of this problem that this research work intend to also examine whether characteristics of the internal audit function (IAF) relating to competence, objectivity, and nature of work performed reduce the external audit fees.

RESEARCH QUESTION

In order to examine the relationship between internal auditing and external audit fee, this research question was considered.

1.     Is there a positive relationship between external auditor’s fees and internal auditor’s competence?

2.     Is there a positive relationship between external auditor’s fees and internal auditor’s objectivity?

3.     Is there a positive relationship between external auditor’s fees and internal auditor’s nature of work performed?

1.4       OBJECTIVE OF THE STUDY

The objective to this study is:

1.     To find out if there is a positive relationship between external auditor’s fees and internal auditor’s competence.

2.     To find out if there is a positive relationship between external auditor’s fees and internal auditor’s objectivity.

3.     To find out if there is a positive relationship between external auditor’s fees and internal auditor’s nature of work performed.

1.5       SIGNIFICANCE OF THE STUDY

The study is of relevance to corporation and auditors due to their desire to strengthen internal controls and reduce audit fee by relying on internal auditors. (Wanda A., Wallace, 1984). Evidence on the work suggest that unexpected external audit fees are significantly lower for companies where the head fo internal audit reports to the audit committee; however, this result does not hold in some analysis because the time internal auditors spend performing financial work is positively related to unexpected external audit fees. (Wood D.A., 2007). This research will explore these aspects of the study and make an attempt to give solution or make suggestion as to how the internal audit function (relating to competence, objectivity, nature of work performed) and fees paid to external auditors will be enhanced.

SCOPE OF THE STUDY

This study examines the effects of internal auditing on external audit fees. It suggests that external auditor’s reliance decisions are based heavily on quality related factors specified by external auditing standards (i.e. the competence, objectivity of, and work performed by internal auditors). The study focuses on the listed companies of the Nigerian Stock Exchange (NSE) as at December 31st 2006.

STATEMENT OF HYPOTHESES

The hypotheses were formulated based on the foreseen problem of the research work.

1.     There is a positive relationship between external auditor’s fees and internal auditor’s competence.

2.     There is a positive relationship between external auditor’s fees and internal auditor’s objectivity.

3.     There is a positive relationship between external auditor’s fees and internal auditor’s nature of work performed.

1.8       LIMITATIONS OF THE STUDY

Result indicates that the time internal auditors spend performing financial work is positively related to unexpected external audit fees. None disclosure of information, record keeping of financial statement and inadequate resources (fund) is a drawback to the study.